Understanding the Price-to-Earnings Ratio

What It's About

Price earnings ratio is the current market price of a company share divided by the earnings per share of the company. What does it all mean?

Stock prices are not just wiggling numbers that go up and down over time. They’re the continually updated pricing on a real, live business. But what do you get for the price you pay? That’s what the P/E ratio tells you. It stands for the price-earnings ratio, and it shows how much the market is charging for each dollar of the company’s earnings. It’s a shorthand way to see how expensive a stock is. Here’s what you need to know about the P/E ratio.

How the P/E ratio works

Investors need a quick way to determine how expensive a stock is, and the P/E ratio is the most popular way to do that. The rationale for using the P/E ratio is simple. As a part owner of the business — that’s what a stock is, after all — the P/E shows how much profit you would receive annually for every dollar that you invest in the company. A high P/E means you’re paying a lot for each dollar of earnings, while a low P/E means profit is relatively cheap.

The P/E ratio is the most popular shorthand valuation metric, but investors use many others, including the price-to-sales ratio for companies that don’t yet have profits.

So what is a high P/E ratio? That depends a lot on the industry and the speed at which a company is growing. Some industries, such as tech, have better business models and can grow profits faster than others. Investors will pay a much higher price for fast-growing companies, those growing profits at more than 10% annually, than they will for slow-growing ones. But as a general guideline, the faster the company can grow its profit, the higher its P/E ratio.

Here are some rough guidelines for thinking about what the P/E ratio is telling you:

  1. Over 25 – a high price, and investors expect high growth
  2. Between 11 and 20 – an average price, and investors expect medium growth
  3. Below 10 – a low price, and investors expect little or no growth, maybe even a decline in profit

It’s important to note that P/E ratios aren’t merely an objective valuation of a company’s earnings growth. They also show investors’ expectations of future growth, building in investors’ fear and greed, excitement and anxiety.

Smart investors make a lot of money on the mismatch between expectations and reality. They often look for hidden companies that will grow quickly with low P/E ratios, showing that the market doesn’t expect much from them. The companies then grow fast, the P/E rises, and these investors make money. However, if investors are expecting high growth and don’t see a company deliver it, they’ll quickly move the P/E ratio — and the stock price — lower. But there’s even a way to make money on falling stocks.

Two types of P/E ratio

As an investor, which is more meaningful to know? A company’s profit last year or next year’s profit? Good investors are always looking ahead, rather than behind, trying to figure out how a company will perform in the future. Of course, no one knows for certain how a company will perform, but we do have concrete information about a company’s past profit.

So that leads to two kinds of P/E ratio:

  1. The trailing P/E ratio — the P/E based on last year’s earnings  
  2. The forward P/E ratio – the P/E based on analysts’ estimates of next year’s earnings

Both can be helpful for thinking about how the market is pricing a stock, but without more context they may be misleading. For example, sometimes a company that’s trading at a high trailing P/E is not expensive, because it’s pricing in next year’s profit. Similarly, sometimes a company trading a low trailing P/E is pricing in a substantial fall in next year’s earnings. So it’s important to consider what the P/E ratio is telling you in context.

How to determine the P/E ratio

It’s relatively simple to figure the P/E ratio of a company, and most financial websites already do the work for you, though they usually provide only the trailing P/E. If you want the forward P/E ratio in order to have more context, you’ll have to do a little legwork yourself. But it’s easy.

There are two ways to find the P/E ratio, but they amount to the same thing:

  1. Find the company’s stock price and divide by its reported earnings per share over the last year.
  2. Find the company’s market cap and divide by its total profit over the last year.

Both methods will provide the same P/E, of course, but it’s the trailing P/E. However, if you’re looking for a company’s forward P/E, you’ll want to find what analysts expect the company to earn next year. This figure is often available on financial sites, such as brokers’ pages, and is often reported in terms of earnings per share, rather than in total profit. If you have the earnings per share, you can simply use the first method and get the forward P/E.

There’s more than just the P/E ratio

The P/E ratio is the most popular shorthand valuation metric, but investors use many others, including the price-to-sales ratio for companies that don’t yet have profits. Whichever metric they use, investors are trying to understand the price they’re paying and the value they get.

By Mackenzie O'Connor
Wealthbase Contributor

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